How to Enhance Performance and Income in Bond Strategies
While the recent rise in interest rates has provided near-term relief, historically low interest rates continue to stifle bond income and investors are seeking other ways to generate return and outperform. But they struggle with limited options — bets related to either credit quality or duration. This, in turn, limits potential for outperformance. However, the options are expanding. Our research shows that a technique to drive outperformance in equity strategies also shows promise for bond strategies.
The Limited Bond Investing Toolbox
We’ve found that investors’ overweights or underweights to duration and corporate credit versus a market benchmark drive upwards of 70%* of the variation in bond manager excess returns**. Duration is how much a bond price moves when interest rates move. The price of a higher duration bond, which usually has a longer term maturity, rises and contributes more to returns when interest rates decline. Credit is associated with a company’s financial performance. A company’s bond price will rise if it performs better financially than most investors expect. In essence, driving outperformance in the bond world largely comes down to pulling just these two levers.
These limitations exacerbate the already low income investors receive from bonds, depressing total return, because of persistently low interest rates. Yield across bond classes — including high yield, U.S. and European government, investment grade, and emerging market bonds — are near multi-decade lows. Understandably, investors are seeking alternative ways to generate return and outperform with their bond investments.
Applying a Proven Path to Historical Outperformance
Investors will discover such an alternative across the proverbial financial- markets pond in the stock market. Academic studies and our research show that, over the long-term, some types of stock with certain characteristics called factors^ consistently outperformed the stock market on a risk adjusted basis. Factor-based investing is a form of systematic investing that involves selecting securities based on characteristics that are associated with higher expectations of excess returns. These factors can be broadly categorized as low volatility, high quality, high dividend, value, small caps and momentum. Recent academic studies have found that bonds with most factors also have outperformed.^^
By selecting bonds based on these factors, we believe investors can construct strategies that generate competitive income without taking more risk. Exhibit 2 shows an investment grade strategy invested in bonds with strong quality and value characteristics. The strategy provides a higher yield with a lower default estimate than benchmarks with similar average durations and credit ratings. In other words, the strategy boosts income and lowers risk through factor investing while remaining neutral in other areas. This positioning forms the hallmark of any factor-based strategy. Investors focus on taking risk-efficient bets that pay (factors) while otherwise intentionally positioning their strategies close to the benchmark with sector weightings, credit rating, duration and other areas.
Factor Performance for High Yield Bonds
The effectiveness of factor-based investing extends into other bond sectors. Exhibit 3 shows that some factors have historically outperformed in particular in the high yield bond market. Investors can use strategies of a single factor or multiple factors to achieve targeted outcomes. Importantly, they should consider liquidity with factors such as momentum, in which high turnover can trigger trading costs that eat into returns.
A Larger Bond Investing Toolbox
Factors, standing on the shoulders of decades of empirical research, expand bond investors’ options to enhance performance with consistent risk-adjusted returns. In an environment where every basis point of return matters and opportunities to generate income are challenging, we believe investors should consider applying factor-based investing strategies to their fixed income portfolios.
Explore factor-based investing at Northern Trust Asset Management.
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*Mehta, Azeredo, Good Luck or Skill: Can fixed income managers time market environments? (2021), Mladina, Peter, Bond-Market Risk Factors and Manager Performance (September 2019). Khan, Ronald, and Lemmon, Michael. “Smart Beta: The Owner’s Manuel.” The Journal of Portfolio Management(Winter 2015).
**Excess returns above the one-month Treasury bill rate
^Mehra, Rajnish; Edward C. Prescott (1985). “The Equity Premium: A Puzzle”. Journal of Monetary Economics 15 (2): 145–161. Carhart, M. M. (1997). “On Persistence in Mutual Fund Performance”. The Journal of Finance 52: 57–82. Goyal, A. and Sunil Wahal (2008). “The Selection and Termination of Investment Management Firms by Plan Sponsors”. Journal of Finance 63: 1805–1847.
^^Mehta, Hunstad(2017), Looking Beyond Term and Credit: Factors that drive performance of European Corporate Bonds. Israel, R., Palhares, D., and Richardson, S. (2016), Common Factors in Corporate Bond and Bond Fund Returns, Bektic, D. & Neugebauer, U. & Wegener, M. & Wenzler, J.-S., 2017. “Common Equity Factors in Corporate Bond Markets,” Publications of Darmstadt Technical University, Institute for Business Studies (BWL)
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